Question

Imagine a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to:

(a) The ratio of the market value of the equity to income after interest if M&M propositions are right?

(b) The ratio of the market value of the firm to income before interest if M&M propositions are right?

Answer 1

1 When the leverage is increasing, it will mean that the overall cost of equity of the company will be increasing and it will also mean that the net income after the interest payment to the value of the equity will be increasing.

When the Modigliani Miller approach is followed, it will mean that inclusion of debt capital will be leading to reduction in the cost of equity, and it will also mean that the ratio of market value of equity to Income after interest will be DECREASING

2. Ratio of the market value of the firm to the income before interest will be INCREASING because the overall value of the firm will be increasing after inclusion of debt capital so it will mean that if the modigliani-miller position is right it will lead to increase in the value of company after inclusion of leverage and it will be leading to INCREASE in the ratio of market value of firm to Income before interest.